Shorts Are Piling Into These Stocks. Should You Be Worried?

The best thing about the stock market is that you can make money in either direction. Historically, stock indexes have tended to trend up over the long term. But when you look at individual stocks, you'll find plenty that lose money over the long haul. According to hedge fund institution Blackstar Funds, even with dividends included, between 1983 and 2006, 64% of stocks underperformed the Russell 3000, a broad-scope market index.

A large influx of short sellers shouldn't be a condemning factor for any company, but it could be a red flag from traders that something may not be as cut-and-dried as it appears. Let's look at three companies that have seen a rapid increase in the number of shares sold short and see whether traders are blowing smoke or if their worry has some merit.

Source: The Wall Street Journal.

Cleared for takeoff?
If I didn't know any better, I'd say we're certainly seeing a trend among short sellers and the airline sector. During the same period last week, we took a closer look at Delta Air Lines (DAL -0.45%) which had seen a 135% spike in short interest, presumably due to the prospect of higher fuel costs with oil near a two-year high and jet fuel prices following suit. Many of these same fears are being experienced by Southwest Airlines. Admittedly, fuel costs are the No. 1 expense for Delta and Southwest and, without proper hedging, have the potential to wreck an otherwise profitable quarter. But is Southwest really in bad shape?

In the airline sector, I'd have to say Southwest is one of the more sound plays. That's certainly a bit of a stretch as I generally go out of my way to avoid sectors that have incredibly high input costs for extremely low returns, but Southwest has advantages that few other airlines like Delta possess.

For one, Southwest has incredibly high customer loyalty thanks to its "bags fly free" program. Consumers really dislike paying for optional fees like baggage, and Southwest can charge more up front in the ticket price if need be to collect the same profit from consumers were it charging for bags.

Another important factor is that Southwest focuses predominantly on domestically underutilized routes. Sure, everyone flies to Atlanta, New York, and Los Angeles, but Southwest focuses on other metropolitan areas that are vastly underserved by the major carriers. The result is better pricing power and surprisingly strong demand.

Having turned a profit for 40 straight years, unless oil shoots over $130/barrel, I wouldn't even consider betting against Southwest.

OshKosh B'gosh, this is pricey!
It's been a very good year for shareholders of Carter's, the largest domestic-branded marketer of apparel for babies and children. In the second quarter, shareholders were privy to a 9.7% increase in net sales, with international sales skyrocketing 44.9%. Furthermore, Carter's also announced an additional $400 million accelerated buyback authorization, which boosted its existing share repurchase program to a whopping $700 million.

However, there were also some disconcerting signs mixed into this report, and after this report as well. Domestic OshKosh brand sales fell 4.7%, although they accounted for only 13% of total quarterly sales. Another oddball move, it's financing its share repurchase with a $400 million debt offering. Going into debt just to repurchase shares would rank up there among the ultimate no-no's in my list of "things to never do."

Ultimately, this comes down to consumer growth versus Carter's somewhat premium valuation. Internationally, Carter's brands are a hit, but they're unfortunately just 10% of total sales at the moment. That leaves Carter's somewhat exposed to weakening consumer spending, which we've seen throughout much of the retail sector. Yes, it operates in a niche for babies and young children, but rarely do retailers escape a downtrend when it hits this much of the sector. Even with improved EPS estimates, Carter's is valued at what I feel is a premium 19 times next year's earnings. Unless it can manage to revive growth in its OshKosh brand domestically, I'd probably keep to the sidelines at these levels.

Get a drink of this...
You wouldn't know by its share price, but bottling company Coca-Cola Enterprises has had its fair share of struggles in Western Europe this year. The company, which derives about 90% of its revenue from bottling non-alcoholic beverages overseas for Coca-Cola (KO -0.24%), is dealing with higher French excise taxes, negative currency translation, and in general a region that is struggling under heavy austerity measures. With short sellers piling on, the question then becomes: Are shares priced for perfection?

Although they are nowhere near the value they were earlier this year, I have a hard time betting against Coca-Cola Enterprises for three reasons -- the first being that it sold its North American operations back to Coca-Cola in 2010. This sale allowed it to exit a very competitive bottling market and focus on Western Europe, which really does offer a faster rate of growth potential.

Second, a majority of Coca-Cola Enterprises' revenue comes directly from Coca-Cola products. Coke's products are pretty much the most recognized in the world, meaning little advertising is needed to achieve brand awareness. In other words, the products sell themselves.

Finally, many of Coke's products are immune to recessions. I wouldn't go so far as to call Coca-Cola's products a basic necessity, but chances are that few consumers are going to cut down their consumption because of the austerity measures in Europe. It may leave Coca-Cola Enterprises with weaker growth over the next year or two, but its cash flow continues to remain strong.

I may not be chomping at the bit as a buyer here, but I wouldn't consider betting against Coca-Cola Enterprises, either.

Foolish roundup
This week's theme is all about niche businesses. Coca-Cola Enterprises, Carter's and Southwest have all moved into areas where their peers really haven't, giving all three a comparative advantage. My one reservation of the three would be Carter's given the weakness we've witnessed in domestic retail and its already premium valuation relative to the sector.